When forming a new business, the entity’s legal structure can be just as important as its purpose. Below are brief descriptions of various business structures and some of their Pros and Cons.
Sole Proprietorship
Sole Proprietorships are non-registered, unincorporated businesses with just one (1) owner and no legal distinction between the business and the owner. Therefore, the owner receives the business’s profits and is responsible for the business’s debts, losses, and liabilities. The proprietor is an individual and cannot be an entity.
Pros:
- Sole proprietorships do not file a separate tax return from their owner’s personal income tax return.
- Easy to start and maintain, generally with minimal legal costs and no ongoing filing requirements.
- Owners of a sole proprietorship have complete individual control over the management of the business.
Cons:
- Owners of a sole proprietorship have personal liability for the debts and obligations of the business.
- As a sole proprietorship cannot sell stock or membership interests, it can be more difficult to raise capital or cash than a corporation or limited liability company.
- As the business is not a separate legal entity, it does not continue upon the owner’s death or incapacitation.
General Partnership (GP)
This form of partnership is the default form and is more straightforward than a Limited Partnership. A GP is formed when two or more partners agree to go into business together. However, the partners can also create a formal partnership agreement that provides specific details on each partner’s role(s). Each partner can own any share of ownership, but the total ownership of all partners must equal 100%. Like a sole proprietorship, the partnership does not pay any tax and divides income and expenses among the partners.
Pros:
- GPs do not pay taxes at the business entity level. The business’s income and losses are “passed through” to its partners, who report them on their personal income tax returns. This pass-through avoids the double taxation issue faced by C-corps, described below.
- No state filings are required. The GP exists when the partners begin business activities and, absent a formal partnership agreement, ends when the partners decide.
- Without a formal partnership agreement, Partners in a GP share control over the management of the business, allowing an even distribution of the workload.
Cons:
- Partners have unlimited personal liability for their actions, the actions of other partners, and the actions of any employees of the partnership. If someone sues the partnership, the partners share responsibility for any damages. This type of liability is known as Joint liability.
- Example: Partner A and Partner B receive a loan to purchase office space. If Partner A were to go bankrupt, Partner B would still be liable for the loan balance and vice versa.
- In some states, partners may also be jointly and severally liable, meaning each partner is liable for up to 100% of the amount at issue, not just their proportionate 50% share.
- Example: Partner A and Partner B receive a $100,000 loan to purchase office space. The loan goes into default, with $50,000 remaining as an outstanding balance. The bank sues Partner A for the entire $50,000 balance (perhaps because Partner B has declared bankruptcy or is otherwise financially compromised). To be made whole, Partner A will have to pursue Partner B for his $25,000 overpayment of that liability.
- Partners owe specific fiduciary duties to the GP, such as loyalty, care, good faith, and fair dealing.
Limited Partnership (LP)
An LP is made up of two types of partners: one or more Limited Partners, whose liability is generally limited to the amount of their investment, and one or more General Partners, who have unlimited liability. In an LP, General Partners are directly involved in the management decisions of the partnership. At the same time, Limited Partners are usually passive investors who are not involved in the direct management of the partnership. Each state generally governs the Formation of LPs and requires registration with the local Secretary of State.
Pros:
- Limited Partners in an LP have no personal liability for the acts of the LP or the other partners. Additionally, creditors cannot make a claim on the personal assets of the Limited Partners, e.g., their homes or bank accounts, to satisfy the partnership’s debts. Their liability is limited to the amount of their investment in the LP.
- LPs do not pay taxes at the business entity level. The partnership’s income and losses are “passed through” to its partners, who report them on their personal income tax returns. This “passing through” avoids the double taxation issue faced by C-corps, described below.
- General Partners in a GP have complete individual control over the management of the business.
Cons:
- General Partners typically have unlimited joint or “shared” liability for the debts and obligations of the LP. Additionally, creditors can make a claim on the personal assets of the General Partners, e.g., their homes and bank accounts, to satisfy the partnership’s debts.
- LPs have more significant compliance requirements than GPs, including, but not limited to, filing a certificate of partnership that identifies all partners, annual investor meetings, and providing all partners with access to the partnership’s financial records and books.
- Limited Partners are allowed only limited involvement in the partnership’s management. If they are deemed non-passive, they lose their personal liability protection.
Corporations
All corporations have directors, officers, and shareholders. Unlike partnerships and sole proprietorships, a corporation is a distinct legal entity from its shareholders.
C-Corporation
C-corporation or C-corp is a tax classification used by corporations and not a business entity by itself. It is named for subchapter C of the Internal Revenue Code, which describes its tax designation. C-corporations are the default corporation under IRS rules. C-corps pay corporate income tax, and then their shareholders pay taxes on any gains realized on dividends paid by the C-corp or sales of its stock.
Pros:
- Employees, shareholders, directors, and officers of a C-corp typically have no personal liability for the acts of the company or the other shareholders. Exceptions arise when creditors pierce the corporate veil by showing that the shareholders did not treat the corporation as a separate and distinct entity from themselves as individuals. Examples include shareholders who treat corporate funds as their piggy banks. Assuming creditors do not have grounds to pierce the corporate veil, they typically cannot make a claim on the shareholders’ personal assets, e.g., their home or bank accounts, to satisfy the business’s debts.
- Corporations can last forever as they are not dependent on the existence of a specific individual like a sole proprietorship. Additionally, transferring shares of a corporation’s stock has no impact on its existence.
- Anyone and any number of people can own and sell shares of a C-corp’s stock, and when sold, the new shareholder will inherit all the rights included therein.
- C Corps may have different classes of stock, such as common, preferred, voting, and non-voting. This flexibility allows shareholders to enter at different share prices and participation levels, which can be beneficial when raising capital.
Cons:
- C-corps are expensive to start due to fees required when filing Articles of Incorporation, and their state may require additional annual fees. Further, the corporation must obtain a registered agent in their state of domicile.
- Earnings of a C-corporation are taxed at both the corporate level, generally 21%, and the shareholder level; this is referred to as “double taxation.” Further, the corporate losses of a C-corporation cannot be deducted by its shareholders on their personal tax returns.
- C-corps are governed by strict rules and regulations that control their business operations, including, but not limited to, annual meetings, bookkeeping and reporting requirements, the use of the accrual method of accounting[1], etc.
S Corporation
S-Corporation, like C-Corporation, is a tax classification named for the subchapter of the Internal Revenue Code that describes their tax designation, in this case Subchapter S. However, unlike C-corps, a corporation must make a tax election to be treated as an S-Corporation and meet specific requirements. Specifically, the corporation:
- Must be a domestic corporation;
- Have only allowable shareholders;
- May be individuals, certain trusts, and estates; and
- May not be partnerships, corporations, or non-resident alien shareholders.
- Have no more than 100 shareholders;
- Have only one class of stock (i.e., no distinctions are allowed as to common, preferred, voting, and non-voting as you find with C-Corps); and
- Must not be an ineligible corporation, which includes certain financial institutions, insurance companies, and domestic international sales corporations.
Pros:
- S-corps do not pay taxes at the business entity level. The business’s income and losses are “passed-through” to its shareholders, who report them on their personal income tax returns. This “passing through” avoids the double taxation issue faced by C-corps.
- Assuming creditors cannot pierce the corporate veil, shareholders of an S-corporation typically have no personal liability for the company’s or the other shareholders’ acts. Additionally, creditors cannot make a claim on their personal assets, e.g., their home, bank accounts, to satisfy the debts of the business.
- Owners of an S-corporation can receive both salary and dividend payments from the corporation. This feature can lower the owner’s taxes, as dividends are not subject to self-employment tax, and the S-corp can deduct the cost of wages it pays when determining the income to be passed through to its shareholders.
Cons:
- As with C-corps, S-corps must pay to file Articles of Incorporation, obtain a registered agent, and may face annual reporting and franchise tax fees.
- Removing assets or cash from an S-corp requires categorizing the withdrawal as either compensation, a dividend, a loan, or other payment, which can produce unwanted outcomes, including, but not limited to, withdrawals classified as compensation requiring the payment of payroll taxes and loans requiring loan documentation.
- Stock offerings may be less effective due to the need to issue a single class of stock with identical rights for dividends and distribution.
Limited Liability Company (LLC)
LLCs can be considered a hybrid between a corporation and a sole proprietorship or partnership. They provide their members the same legal and financial protections as a corporation while allowing taxation to pass through to the members, as with a partnership. However, unlike a partnership, an LLC separates the business assets from the owner’s assets.
Pros:
- Assuming creditors do not have grounds for piercing the corporate veil, members of an LLC typically have no personal liability for the LLC or the other members’ acts, and creditors cannot claim on the members’ personal assets, e.g., their homes and bank accounts, to satisfy the business’s debts.
- LLCs generally do not pay taxes at the business entity level. The business’s income and losses are ” passed through” to its owners, who report them on their personal income tax returns. This “passing through” avoids the double taxation issue faced by C-corps.
- Individuals, partnerships, trusts, or corporations can all be members of an LLC, and the number of members is unlimited.
- As with a C-Corp, an LLC may establish different classes of members, with distinctions in priority as to distributions and voting.
Cons:
- Members of an LLC must pay self-employment tax on income that is “passed-through” to them in addition to their personal income tax.
- Transferring or altering ownership in an LLC can be more complex than in a corporation. Generally, unless the LLC agreement or the members agree otherwise, all members must approve adding new members or altering existing members’ ownership percentages.
- Private equity groups typically prefer to invest in corporations as they dislike the pass-through nature of the LLC’s tax structure.
If you have questions about the type of entity that best suits your business needs, please contact Penwell Law.
[1] Certain corporations may be classified as “small corporations,” and if they satisfy the IRS’ gross receipt test, they may be able to avoid this restriction.
Sources:
- Choose a business structure. https://www.sba.gov/business-guide/launch-your-business/choose-business-structure
- Six major types of business structures. https://www.wolterskluwer.com/en/expert-insights/options-for-business-structure-types
- The Pros and Cons of Different Business Structures. https://www.linkedin.com/pulse/pros-cons-different-business-structures-leonardlyonsolutions/
